The Basics of a CFD Transaction
Dealing in CFDs is almost the same as using a traditional stockbroker to buy or sell shares, including the same dealing price. Look at this example -
- Two traders, Trader A & B, both believe that Vodafone (ticker VOD) will rise over the next few days
- Trader A is going to buy the shares using a traditional stockbroker
- Trader B will use CFDs
Trader A – Buys the shares using a stockbroker
- He calls his stockbroker at 11am and asks the current market quote for Vodafone (VOD)
- The broker quotes him £1.30 - £1.31
- He buys 1,000 shares at £1.31 and pays regular commissions and Stamp Duty (0.5%)
Trader B – Buys the shares using CFDs
- He calls his CFD broker also at 11am asking for a quote on Vodafone (VOD)
- The CFD broker quotes him the same price £1.30 - £1.31
- He buys 1,000 shares using CFDs at £1.31
- He pays commission on the deal but NO Stamp Duty (it’s not levied on CFD transactions)
Both traders now have the same position but they are using different tools. Trader A owns the shares and has had to pay the full amount (£1,131 without considering costs). Trader B doesn’t own 1,000 shares but instead owns a contract (the CFD) that will mimic the profit or loss profile of Vodafone.
If the shares therefore lose 17% or gain 28% both traders will make the same amount of money (costs excluded). But this is the key - trader B, who used CFDs will have only had to deposit 10% to 20% of the total cost, the balance will have been lent to him by his CFD broker. More on CFD financing and how it works.
Who Owns The Shares In A CFD Transaction?
What is interesting in both of the above examples is 1,000 shares in HBOS were bought by both the traditional stockbroker and the CFD broker. But while the stockbroker who's acting for Trader A, passed on the physical shares to his client, the CFD broker didn’t.
The CFD broker kept the shares in his company's account but has made an agreement with Trader B to pass on 100% of both the profits and losses of the share price movement. In effect CFD clients are not interested so much in the physical shares, rather the profit and loss of the share price movement.
This is why CFDs are not meant for investment purposes. As well as why they're popular for quick short term trades. When a client uses CFDs it's not about owning the company's shares per se, rather owning the right of the share price movement.
How CFDs Can Be Used To Short Sell Stocks
CFDs are perfect trading vehicles for shorting either the overall market, via an index like the FTSE 100, or on individual shares.
If we again take the Vodafone example. Trader A using his regular stockbroker cannot short shares because the London Stock Exchange does not offer this facility for retail clients. But Trader B can easily use CFDs to short the shares.
- Trader B's CFD broker quotes him a market of £1.30 - £1.31 in Vodafone
- He sells short 1,000 shares at £1.30
- 3 days later he buys the shares back at £1.20 making a profit of 10p per share (excluding costs)
But how can Trader B sell shares he doesn't own? Because the shares sold are borrowed by his CFD broker, perhaps from a large institutional investor who owns millions of them. Fund managers obviously own many shares and while most people think there are only two ways for an institution to make money via the shares they hold, there are three -
- The share price can go up
- The company can pay a dividend
- The shares can be lent (for a small fee) to another financial institution, in this case a CFD broker
- For Trader B to sell short 1000 shares in Vodafone the CFD broker borrows shares from another entity
- These shares are then sold in the market
- When Trader B decides to cover his short position (whether at a profit or loss) he buys 1,000 shares which are then returned to the original owner
- It's a win-win-win for all three parties involved
- The trader has the ability to short, the CFD broker earns commission and the Fund Management company earns a small fee for lending the stock (this fee is normally taken care of by the CFD financing rates)
Does all of this sound complicated? On paper it might do but in reality what goes on behind the scenes is taken care of by the CFD broker.
For example, if you call up and want to sell short 1,000 Vodafone the deal can be done in seconds. You won’t have to hang on while the broker calls around trying to find the shares to borrow and negotiate a fee etc.
Your job should be to understand the basics but don’t concern yourself with the paperwork. Most of your effort should be spent analysing the market or individual shares and working out whether they’re going up or down. Let the back office and your broker take care of everything else.
